Big deal: the other day, J.P. Morgan Chase & Co. filed its quarterly report with the Securities and Exchange Commission.

Nothing unusual in that. The bank had already done the dirty work by announcing its second-quarter results on July 17. And in that report, everything was looking up. J.P. Morgan had a $2 billion profit to show. The only apparent downer was the $500 million in charges taken for the acquisition of Bear Stearns Cos.

So Monday's filing really wasn't much more than making it all official. Generally, 10Q's are just the numbers with the legal stuff thrown in. Sure, between the time when results are announced and when the filing is made, things can change. It happens, but when it does, it's generally a surprise.

You probably know by now that J.P. Morgan's 10Q did include one of those surprises. Slipped in on page 10 of the report was a disclosure that its investment banking arm held some collateralized debt that had lost about $1.5 billion in value since the end of the quarter.

J.P. Morgan tells me that they weren't trying to hide anything. They say it was at the top of the filing and those filings are highly scrutinized. Maybe so. On the other hand, they didn't give this the fanfare the second-quarter profit received: press releases and conference calls. In other words, it took about a month, maybe less, for J.P. Morgan to lose about 75% of its second quarter profit.

It doesn't get much worse, or does it? J.P. Morgan, a bank many -- including me -- thought had weathered the banking crisis and moved on, said it could get worse and may be worse already because the investment bank still had a $19.5 billion exposure in Alt-A mortgages, $1.9 billion in subprime mortgage exposure and an $11.6 billion exposure in commercial mortgage-backed securities. For these securities, though hedged, "the trading conditions have substantially deteriorated," the bank said.

Anyone get the feeling that the banking and credit crisis is about to get worse? We may be waiting a lot longer than the third quarter for the bleeding to stop. J.P. Morgan seems to be taking one of the two strategies that have emerged during the crisis: hold onto the junk and hope the market turns. This is the same plan that's in place at Lehman Brothers Holdings Inc. and was in place at Bear Stearns Cos.

There's a technical term for the other strategy that's being employed at Merrill Lynch & Co. and to some degree at Citigroup Inc. dump it. Merrill employed this strategy back on July 29 when it took a healthy haircut and accepted 22 cents on the dollar for about $30 billion in collateralized debt obligations that were stinking up the balance sheet. About the only good news the market took from this was that there was actually someone willing to buy it.

The point is that even though there are different strategies, there is a single truth: the books on Wall Street are still loaded with stuff that stinks. Not everyone is holding their noses. Brad Hintz, the Sanford Bernstein analyst and former chief financial officer at Lehman, is among the best who have assessed the situation. He doesn't think the Alt-A loans and the subprime loans are going to be a problem. Most of that stuff has been written off.

"After all, the marks can't go past zero," he wrote me in an e-mail. That doesn't mean Hintz is whistling like Frank Quattrone past the courthouse. He's worried about a couple of things: commercial mortgage backed securities, the kind J.P. Morgan copped to having $11.6 billion worth, and good old prime mortgages, which like the Titanic would never default and are now taking on water.

If the prime stuff goes, the whole system implodes and we're all sleeping in the park. The commercial stuff is more likely to fail. "Commercial whole loans are difficult or impossible to hedge and knowledgeable players in the commercial mortgage market are attempting to sell their positions while they still can. So we may be seeing a sequel to August 2007 but without the fraudulent borrowers and without the no-money down issues," Hintz said.

The good news is that commercial mortgage underwriters never gave them out at souvenir night at the ballpark like the residential guys did. They weren't gymnastics judges, but the commercial guys had, at least, some standards.

OK, but I have to disagree with Brad on one issue. He says most of the Alt-A and subprime write-offs are finished. The numbers seem to back him up, too. A rough count by Bloomberg on Tuesday found that the world's 100 biggest banks had written off $510 billion. That sure beats Reuters' tally of $341 as of July 30, but both are huge numbers and it's been more than a year since these securities have gone belly up.

The answer is found in J.P. Morgan's announcement and Merrill's asset sale. The market didn't see either of them coming. At J.P. Morgan, most analysts took the $2 billion profit at face value and pronounced a turnaround. Deutsche Bank's Mike Mayo wrote J.P. Morgan is "one of the few financial firms that are playing offense and showing revenue growth."

The outlook on Merrill was the same. Most analysts estimated Merrill had less than $20 billion face-value exposure to risky CDOs and other borderline securities after it announced a worse than-expected write-down of about $9 billion on July 17. Remember, Merrill sold $30 billion at a 78% discount a few days later.

No one really knows what's lurking in the vaults of Wall Street, but we do know we can't call an end to this mess. It says so right on page 10 of that filing J.P. Morgan made on Monday. You might remember, the disclosure that sent the market reeling by nearly 100 points? No big deal

"The market is pricing in a significant cut, roughly 50 percent or more," said Steve Sosnick, who trades options at Interactive Brokers Group Inc. in Greenwich, Connecticut, which handles a seventh of global equity options trading.

A reduction would be Merrill's first since it went public in 1971 and represent another reversal for Thain, 53, who told analysts he had plenty of capital two weeks before last month's record $9.8 billion stock offering. The sale lifted the burden of quarterly payouts by boosting shares outstanding by half.

The company has paid 35 cents a share since the first quarter of 2007, when Merrill's board raised it from 25 cents. The board reaffirmed the payment on July 30. Yet a reduction to 18 cents for the fourth quarter is reflected in the market, Bloomberg data show. The data compare prices for different Merrill options and apply formulas commonly used by traders to reflect the probability and timing of dividend payments.

Merrill, the third-biggest U.S. securities firm by market value, has the highest dividend yield among peers, at 5.5 percent. The yield moves inversely to the stock price, which has tumbled by more than 50 percent this year. The shares fell 17 cents to $25.77 as of 9:42 a.m. in New York Stock Exchange composite trading.

Sanford Bernstein & Co. analystBrad Hintz estimated in an Aug. 6 report that Merrill should cut its dividend by 64 percent to about 13 cents, to free up $1.5 billion of capital a year. Fox-Pitt Kelton analyst David Trone said in an Aug. 12 report that Merrill may face more than $5 billion of writedowns in the second half of 2008 and may need the extra capital as a buffer.

Thain, who took over as CEO in December after the ouster of Stan O'Neal, said in an Aug. 4 interview with CNBC that he didn't plan to cut the dividend, in part because many Merrill employees own the stock. His board doesn't need to declare a change in the fourth-quarter dividend until October. "We believe we will shortly be back to profitability and be able to earn the dividend," Thain said. "I prefer to get the yield lower by getting the stock price higher."

Thain wouldn't be alone in failing to honor a dividend pledge. Citigroup Inc. cut its dividend 41 percent last November, two months after Chief Financial Officer Gary Crittenden said the bank was "fully committed" to keeping it steady. In January, Wachovia Corp. CEO Kennedy Thompson said he "didn't need" to reduce the payments, only to lose his job as his bank slashed the dividend more than 90 percent.

The options market predicted Citigroup's January cut, said Sveinn Palsson, a derivatives strategist at Credit Suisse Group in New York. Palsson himself published a report predicting a reduction two months before it happened. "The options market has proven to be a good indicator of upcoming dividend changes," Palsson said. His analysis shows Merrill may cut the dividend to as little as 15 cents a share.

Bank repossessions almost tripled in July and U.S. foreclosure filings increased 55 percent from a year earlier as falling prices cut homeowner equity, accelerating the housing decline, RealtyTrac Inc. said.

Bank seizures rose 184 percent, the most since reporting began in January 2005, the Irvine, California-based seller of foreclosure data said today in a statement. More than 272,000 properties, or one in 464 U.S. households, got a default notice, was warned of a pending auction or were foreclosed on. Nevada, California and Florida had the highest rates.

"It's getting worse," Rick Sharga, RealtyTrac's executive vice president for marketing, said in an interview. "The number of properties that have been foreclosed on by the banks and still haven't sold is the highest we've ever seen."

Total filings rose 8 percent from the previous month to 272,171, just shy of the record 273,001 set in May, said RealtyTrac, which has a database of more than 1.5 million properties. Through July, 775,244 properties were owned by banks, compared with about 445,000 for all of 2007 and about 224,000 in 2006, Sharga said.

Foreclosures are depressing home prices, contributing to job losses and weakening consumption as fewer people borrow against the value of their home, New York-based analysts at Lehman Brothers Holdings Inc. said Aug. 7. U.S. home prices fell 15.8 percent in May, the most since at least 2001, according to the S&P/Case-Shiller home-price index. One-third of home sellers in the second quarter lost money, Zillow.com, a Seattle-based provider of home valuations, reported this week.

Bank seizures, known as real estate-owned or REO properties, are the "fastest growing segment of foreclosure activity," James Saccacio, chief executive officer of RealtyTrac, said in the statement. The REO properties in the company's database represent about 17 percent of the inventory of existing homes reported in June by the National Association of Realtors, he said.

Default notices in July increased 53 percent from a year earlier and auction notices rose 11 percent, RealtyTrac said.The June total of 252,363 reflected an "artificial depression" due to new state laws designed to help homeowners avoid foreclosure, Sharga said.

New York, California, Massachusetts, Colorado and Maryland are among the states that have imposed temporary foreclosure moratoriums or delayed proceedings by as many as 150 days. Those laws will "likely delay the inevitable that most of those properties go into foreclosure," Sharga said.

National legislation is designed to help up to 400,000 homeowners refinance their adjustable-rate mortgages into fixed- rate loans. That bill, backed by the Federal Housing Administration, may help borrowers who take advantage of the state relief, Sharga said. Almost one-third of homeowners who bought in the last five years owe more on their mortgages than their houses are worth, Zillow reported.

Foreclosures could put 8.4 percent of total U.S. homeowners, or 12.7 percent of homeowners with mortgages, out of their homes, according to New York-based analysts at Credit Suisse. About 53 percent of subprime borrowers, those with poor or incomplete credit histories, will have negative equity in their homes this year, and that percentage will rise to 63 percent next year, the analysts said in an April 23 report.

Nevada had the highest foreclosure rate for the 19th consecutive month. One in every 106 households was in some stage of foreclosure in July, and bank seizures rose almost fivefold from a year earlier. Filings rose 15 percent from June and 97 percent from July 2007, according to RealtyTrac.

California had the second-highest rate, with one filing for every 182 households. Bank repossessions rose more than fivefold from a year earlier. Filings increased 5 percent from June and rose 85 percent from July 2007, RealtyTrac said.Florida had the third-highest rate, one filing for every 186 households, while bank repossessions rose almost eightfold. Filings rose 14 percent from June and 139 percent from July 2007.

Arizona had the fourth-highest rate, followed by Ohio, Georgia, Michigan, Colorado, Utah and Virginia, RealtyTrac said.California led with the most total filings, followed by Florida, Ohio, Arizona, Michigan, Texas, Georgia, Nevada, Illinois and New York. New York had the 30th highest rate, one in 1,282 households. New Jersey had the 19th highest rate, one in every 751 households.

For the first time since April, Stockton, California, didn't have the highest metropolitan area foreclosure rate, a sign that "it may have finally found its point of saturation," Sharga said. Cape Coral-Fort Myers, Florida, had the highest rate of the 230 metro areas surveyed, one filing for every 64 households, more than seven times the national average. Three California cities followed: Merced, Stockton and Modesto. Las Vegas was fifth.

Banks and lenders have now foreclosed on $100 billion worth of California homes over the past two years, and are foreclosing at the rate of 1,300 houses every business day, according to a new report from ForeclosureRadar.com.

The report, covering foreclosure activity in California in July, notes that new mortgage defaults are declining, but foreclosures are continuing to rise sharply. "It is clear that far fewer homeowners are finding a way out of foreclosure," the company reports.The pace of foreclosures in California -- 1,300 every business day -- has more than tripled from the year-ago rate of 415 per day, ForeclosureRadar estimates.

Overall, the level of foreclosures in the state increased 22.5% from June to July, ForeclosureRadar reported, while the level of defaults dropped by 4.6% in the same time period. The vast majority of foreclosed homes are taken over by banks -- 96.6% in July, the company reported, although it noted that banks are increasingly offering discounts to investors in hopes of avoiding taking possession of foreclosed houses in the first place.

"Although the declines in Notices of Defaults seem promising, much of this can be explained by the actions of just one lender," said Sean O'Toole, founder of ForeclosureRadar. "Ninety-one percent of the decline in Notices of Default since April can be attributed to Countrywide Financial. Unfortunately, this is more likely due to the challenges of integrating two companies the size of Countrywide Financial and Bank of America, than it is a fundamental shift in foreclosure activity."

The federal housing rescue bill sets aside $4 billion for local governments to purchase foreclosed homes, but O'Toole says that amount is so small relative to the overall pool of foreclosed houses that it will have little economic impact. "$4 billion is kind of a meaningless sum," O'Toole told CNN Money. "It can't possibly make a difference. You've brought a pistol to a nuclear war."

More homeowners than ever are selling at a loss, propelling the real estate market deeper into crisis.In the 12 months that ended June 30, nearly 25% of all homes sold nationwide fetched less than sellers originally paid, according to real estate Web site Zillow.com.

While the nation's double-digit decline in home prices has been well documented, the new report underscores the economic force of those price declines. Homeowners are walking away with much less in their pocket when they sell. And that affects more than the real estate market.

"It's stunning what's happening out there," said Stan Humphries, Zillow's vice president of data and analytics, who looked at statistics that date back to 1996. "The numbers are the worst we've seen and it's not just the magnitude of the problem but the scope - so many markets are affected."

In Merced, Calif., 63% of homes sold during the past 12 months brought in less than what the owner paid. Prices there have fallen 40% over the past 12 months and 56% from their 2006 peak. About 63% of sellers in Stockton, Calif., lost money during the same period, 60% in Modesto, Calif., 55% in Las Vegas and 38% in Phoenix.

And the trend has worsened in recent months. In Merced, 74.9% of sellers took a loss when they sold during the three months ended June 30 compared with just 28.7% during the same period in 2007. The experience of one would-be seller in Cape Coral, Fla., illustrates the kinds of losses sellers are suffering. The homeowner, who asked not to be named, paid $147,000 in 2003 for a three-bed, two-bath ranch. Prices have dropped there more than 22% in the past 12 months.

He said he made a 10% downpayment and spent big on upgrades, including two renovated baths. The house was appraised at $279,000 two years ago. Two months ago: $140,000. He has been trying to sell it for more than a year and has dropped the price to $129,900. "It's terrible," he said. "I'm taking a major loss. I'll probably have to bring a check to the closing."

Many sellers are so underwater that their only solution is a short sale. Elsa Bell, a claims adjuster, bought her Riverside, Calif., house in 2006 for $330,000, using a no-down-payment loan. In April she put the house on the market for $275,000, but it hasn't sold. "The bank is willing to do a short sale, and we have an offer of $170,000 on the house, but we believe the bank will turn that down," Bell said.

A short sale is when a lender agrees to take less than the amount it is owed on a mortgage and forgives the remaining debt. For Bell, whatever the sale brings, it's going to be a lot less than what she paid. The good news is that she should get out of the deal fairly clean. Since she has little invested, she has little to lose. The bad news is that a short sale may mean a hit to her credit score.

Nationwide, nearly a third of all homeowners who bought since 2003 owe more on their homes than the homes are worth. And those that, like Bell, put little or none of their own money into the home purchases, are more likely to try to sell short or simply abandon their homes.

"They hand over their keys and walk away from the homes," says Danielle Babb, a real estate investor, instructor at the University of California Irvine and author of "Finding Foreclosures." That adds to foreclosure rates. Zillow reported that nearly 15% of U.S. existing home sales during the last 12 months involved foreclosed homes. That trend will almost surely continue.

In Stockton, Calif., 2006 buyers now owe a median of nearly $171,000 more than their homes are worth. In Salinas, Calif., 2006 buyers now have median negative equity of $161,000, and in Merced, the figure is nearly $160,000.

A plethora of sellers taking losses can have a chilling effect on people's lives, says Dean Baker, co-director of the Center for Economic and Policy Research in Washington. People don't want to sell at a loss, so they put off their plans, whether it's a move for a better job opportunity elsewhere or trading up to a larger home. "That will delay the [market correction]," said Baker. "It takes time for people to recognize that [these losses] are real."

A quick turnaround is not likely. More than $200 billion in adjustable rate mortgages are scheduled to reset during the second half of 2008, according to the National Association of Realtors, and loans of all types defaulting at high rates. There is also about 11 months of inventory at the current rate of sales. "With $3.9 million unsold homes on the market, prices will have to come down even more before the market stabilizes," said Zillow's Humphries.

Existing U.S. home sales fell to a 10-year low in the second quarter and the median price for a single-family house dropped 7.6 percent as the real estate recession deepened.

The median price tumbled to $206,500 from $223,500 a year earlier, the Chicago-based National Association of Realtors said today. Sales of single-family houses and condominiums fell 16 percent to 4.913 million at an annualized pace. Prices are declining with the U.S. on the brink of a recession, consumer prices rising and 30-year fixed mortgage rates at a six year high last month.

A third of all sales in the quarter were foreclosures or "short sales," in which lenders take a loss on a property, the Realtors said. Bank repossessions almost tripled in July from a year earlier, RealtyTrac Inc., a seller of foreclosure data, said in a separate report today.

"It's getting worse," Rick Sharga, RealtyTrac's executive vice president for marketing, said in an interview. "The number of properties that have been foreclosed on by the banks and still haven't sold is the highest we've ever seen."

U.S. economic growth slowed to 1.8 percent in the second quarter as unemployment rose. Forecasters say home values will drop more. The S&P/Case Shiller home price index that tracks 20 cities may tumble as much as 12 percent this year, McLean, Virginia-based Freddie Mac, the No. 2 mortgage buyer, said in an Aug. 11 report.

The biggest declines reported by the Realtors today were in Sacramento, the capital of California, with a 36 percent drop, followed by the metropolitan area around Cape Coral and Ft. Myers, Florida, down 33 percent. Riverside and San Bernardino, California, tumbled 32.7 percent, and Los Angeles dropped 30 percent, according to the report. The metropolitan New York area, including parts of northern New Jersey and Long Island, fell 5.3 percent, and Boston dropped 11 percent.

Bank seizures of properties in default rose 184 percent to 77,295 in July, according to RealtyTrac. That was the steepest increase since the Irvine, California-based company began reporting data in January 2005. More than 272,000 properties, or one in 464 U.S. households, got a default notice, were warned of a pending auction or were foreclosed on, RealtyTrac said. Nevada, California and Florida had the highest rates, RealtyTrac said.

"In many areas with large concentrations of foreclosure sales, homes are being purchased below replacement cost values," Richard Gaylord, president of the Realtors' trade group, said in the report. Price discounts are spurring buyers in some areas of the country, according to the Realtors report. One quarter of the states had price increases in the second quarter when compared with the prior three months.

"Once the inventory is drawn down, price pressure will return because the costs of construction are rising," Gaylord said.There were 4.49 million U.S. homes for sale at the end of June, the highest in a year, according the Realtors' association. At the current sales pace, that represented 11.1 months' worth, up from 10.8 months' worth at the end of May, the trade group said in a July 24 report.

Foreclosures are depressing home prices, contributing to job losses and weakening consumption as fewer people borrow against the value of their home, New York-based analysts at Lehman Brothers Holdings Inc. said Aug. 7. U.S. home prices fell 15.8 percent in May, the most since at least 2001, according to S&P/Case-Shiller. One-third of home sellers in the second quarter lost money, Zillow.com, a Seattle- based provider of home valuations, reported this week.

Bank seizures, known as real estate-owned or REO properties, are the "fastest growing segment of foreclosure activity," James Saccacio, chief executive officer of RealtyTrac, said in the statement. The REO properties in the company's database represent about 17 percent of the inventory of existing homes reported in June by the National Association of Realtors, he said. Default notices in July increased 53 percent from a year earlier and auction notices rose 11 percent, RealtyTrac said.

U.S. consumer prices climbed more than forecast in July, reducing the ability of the Federal Reserve to lower interest rates should the economic slowdown deepen.

The consumer price index climbed 0.8 percent, twice as much as anticipated, the Labor Department said today in Washington. The cost of living was up 5.6 percent in the year ended in July, the biggest jump in 17 years. So-called core prices, which exclude food and energy, also rose more than projected.

The report may intensify the debate between those Fed policy makers that forecast inflation will slow and those concerned that price pressures will accelerate. Increases beyond food and fuel, including gains in clothing, airline fares and education, make it less likely that central bankers will be able to keep interest rates unchanged for long.

There is "a tremendous amount of cost pressure here that is affecting many, many industries," William Poole, the former St. Louis Fed president, said in an interview with Bloomberg Television. Today's report "raises the general trajectory" of interest rates, reducing the chance of cuts and bringing forward the likelihood of increases, he said.

Still, commodity costs have retreated since mid-July, indicating the rise in total consumer prices may slow. Crude oil futures dropped as low as $112 a barrel this week after topping $147 last month. Regular gasoline, which reached a record $4.11 a gallon on July 17, has fallen about 8 percent, according to AAA.

Treasuries dropped, with benchmark 10-year note yields rising to 3.95 percent at 8:34 a.m. in New York, from 3.94 percent late yesterday. Futures on the Standard & Poor's 500 Stock Index dropped 0.4 percent to 1,279.70. Consumer prices were forecast to rise 0.4 percent, according to the median forecast of 78 economists in a Bloomberg News survey. Estimates ranged from gains of 0.1 percent to 0.7 percent.

Costs excluding food and energy increased 0.3 percent for a second month, exceeding the 0.2 percent median forecast of economists surveyed. The core rate increased 2.5 percent from July 2007, the most since January, after a 2.4 percent year-over-year increase the prior month.

Procter & Gamble Co. was among businesses that responded to the surge in oil earlier this year. The world's largest consumer- products company charged more for Cascade dishwashing detergent, Iams pet food and Gillette razors to offset some of the jump in packaging costs. McDonald's Corp., the world's largest restaurant company, raised prices as ingredient expenses surged.

"Beef and cheese are up, but we've been able to mitigate that cost," Chief Executive Officer James Skinner said in an interview in Beijing last week. The consumer price index is the government's broadest gauge of costs for goods and services. Almost 60 percent of the CPI covers prices consumers pay for services ranging from medical visits to airline fares and movie tickets. Food prices, which account for about a fifth of the CPI, gained 0.9 percent after a 0.8 percent increase in June.

The increases went beyond food and fuel. Clothing expenses jumped 1.2 percent, the most since 1998. The cost of an airline ticket rose 1.3 percent and education expenses climbed 0.5 percent for a second month. Rents which, make up almost 40 percent of the core CPI, cooled. A category designed to track rental prices rose 0.1 percent, compared with a 0.3 percent gain in June.

Policy makers at the Fed's Aug. 5 meeting signaled they're unlikely to change rates as they wait for slowing growth to cool inflation. "Although downside risks to growth remain, the upside risks to inflation are also of significant concern," the Fed statement said. Still, "the Committee expects inflation to moderate later this year and next year."

Today's figures also showed wages decreased 0.8 percent after adjusting for inflation following a 0.9 percent drop in June. They were down 3.1 percent over the last 12 months, the biggest year-over-year decline since 1990. The drop in buying power is one reason economists forecast consumer spending will slow.

Higher gasoline bills and tighter credit reduced automobile purchases in July, causing retail sales to drop for the first time in five months, government figures showed yesterday. Economists John Ryding and Conrad DeQuadros at RDQ Economics LLC in New York are among those not convinced inflation will continue to ebb. The recent decline is just "temporary relief," they said.

"It would be a mistake to view this as a rolling over of the inflation problem and an endorsement of the Fed's policy to keep rates on hold," they wrote Aug. 11. By keeping rates low, policy makers will contribute to a pickup in prices later this year and next, they said.

A jump in the cost of imported goods may also give American companies leeway to charge more, economists said. Prices of products made overseas soared 22 percent in the year ended in July, the most since at least 1982, the Labor Department reported yesterday.

First-time applications for state unemployment benefits fell by 10,000 to stand at 450,000 in the latest week, but in a worrisome sign, the smoothed trend in new claims moved to its highest level in more than six years, Labor Department data showed Thursday.

Initial claims have been boosted in recent weeks by publicity about a new federal program of extended benefits that has encouraged more unemployed workers to file for claims under regular state programs. A Labor Department spokesman could not quantify how many people have been encouraged to apply.

The new program has masked the number of new layoffs, a key gauge of labor market strength as the nation's economy continues to shed jobs. The four-week average of new claims rose by 19,500. At 440,500, this gauge stands at the highest since April 2002.

The number of people receiving state benefits in the week ended Aug. 2 rose by 114,000 to 3.42 million, the most since November 2003. The four-week average of continuing claims also increased, rising 75,250 to 3.27 million, the most since December 2003.

The insured unemployment rate, tracking the percentage of workers covered by unemployment insurance who are receiving benefits, rose to 2.6%, the highest in four years. Compared with the same time last year, initial claims are up about 40%, while continuing claims are up about 32%. Continuing claims have never risen by 20% or more without the economy falling into recession.

Initial claims represent job destruction, while the level of continuing claims indicates how hard or easy it is for displaced workers to find new jobs. Typically, unemployment benefits run out after 26 weeks for those who are eligible. A new law extends unemployment benefits for an extra 13 weeks under a separate federal program.

Benefits are generally available for workers who lose full-time employment through no fault of their own. Those who exhaust their unemployment benefits are still counted as unemployed if they are actively looking for work.

First the borrowers. Now the banks. Federal and state regulators have closed eight banks this year, four since the start of July, as rising borrower defaults on residential and commercial real estate loans start to push some lenders into default, too.

There were no bank failures in 2005 or 2006 and only three in 2007. Now, some analysts expect a few hundred banks to fail over the next several years -- the most since the savings-and-loan crisis two decades ago.

And some critics say the failures aren't happening fast enough. They say regulators are keeping some troubled banks on life support by allowing them to spend money to stay in business that should be reserved to cover loan losses after the bank has failed.

"They are dragging their feet in forcing these banks to reserve realistically," said Bert Ely of Ely & Co., a bank consulting firm in Alexandria. "Some of these banks could have been closed two or three quarters earlier." So far, the banking industry is facing the kind of plague that mostly claims the young and the weak, analysts say. The vast majority of the nation's banks are in stable financial condition.

The failed banks, and those in danger of failing, tend to be smaller institutions burned by overexuberant real estate lending. But as with the impact of foreclosures, the fallout from a relatively small number of failures may end up raising the cost of banking for everyone. One likely consequence is an increase in the insurance premium that banks must pay the Federal Deposit Insurance Corp. to guarantee customer deposits, which now averages 5.4 cents on every $100 of deposits.

James Chessen, chief economist at the American Bankers Association, said banks would "do what's required to ensure the health of the FDIC." But because the premiums are paid with money otherwise available for lending, Chessen said each one-cent rate increase would reduce the collective lending capacity of U.S. banks by about $5 billion.

The banks and their borrowers will thus be paying for the sins of the failed institutions. That has added urgency to the question of whether regulators are doing everything possible to limit the cost of the failures. Some of the recent failures were of banks regulated by the Office of the Comptroller of the Currency, one of several agencies that oversee the country's financial institutions.

Robert Garsson, deputy comptroller for public affairs at the OCC, said that when a bank is losing money, regulators must balance its chance of recovery against the cost of continued losses. "We save a lot of banks by being able to work with them, avoiding failures that would be costly to the insurance fund," Garsson said. "The only ones that people see are the ones that fail."

He noted that the OCC closed the First National Bank of Nevada in July while it still had significant capital reserves, well above the level at which regulators are required to take action, because it concluded the bank could not be saved. Still, critics say the handling of some recent failures resulted in unnecessary expenses for the FDIC's insurance fund.

The question turns on a requirement that banks set aside money to cover possible losses on loans that seem likely to fail. Banks sometimes push to limit the loans classified as problematic, allowing them to keep more money for other purposes. Some critics say regulators have not pushed back hard enough.

As a result, failing banks stay in business longer, sometimes compounding their losses and leaving less money to eventually cover those losses. "In some of these cases, I believe regulators should act sooner than later to prevent future losses to the fund," said Ken Thomas, a lecturer in finance at the Wharton School at the University of Pennsylvania.

The issue may be headed to Capitol Hill, where the Senate Banking Committee plans to hold hearings on bank failures in September with a particular focus on the July collapse of mortgage lending giant IndyMac Bancorp. Sen. Charles E. Schumer (D-N.Y.) has charged that regulatory lapses led to the thrift's spectacular collapse. Regulators say the thrift failed because Schumer scared customers into withdrawing deposits.

During the real estate boom, it was nearly impossible to crash a bank. Loan defaults hit historic lows as borrowers who fell behind on payments simply refinanced. Banks that needed more money found investors eager to buy a piece of a very profitable industry. The absence of bank failures from June 2004 to February 2007 was the longest placid stretch since the 1920s.

Now, however, borrowers who fall behind are increasingly defaulting on their loans, and banks are struggling to survive the resulting revenue shortfalls. When a bank's reserves run out, regulators step in. The branches and the deposits are then sold to another, healthier institution.

This year's first failure came in January, when regulators closed a small bank that served the black community in Kansas City, Mo. There was another failure in March, then two in May. Then, on July 11, came the collapse of IndyMac, an institution larger than the total size of every bank that had failed in the previous 15 years. Three more failures have followed.

There are some common themes, analysts say. The banks paid high interest rates, attracting deposits from around the country to fuel rapid expansion. They focused on commercial or residential real estate lending. And they started lending in unfamiliar places.

ANB Financial, which was closed by regulators in May, was based in Bentonville, Ark. But almost 90 percent of its deposits came from far-flung investors attracted by the bank's high interest rates. And many of its loans were made from offices in St. George, Utah; Jackson, Wyo.; and Idaho Falls, Idaho.

"Ask yourself, 'Why would a borrower be interested in a lender that's three states away?' It's probably because they're having difficulty getting loans from banks that really know that community," said Chessen, commenting on the general pattern but not on ANB specifically.

In mid-July, hedge funds, pension funds and other institutional investors dramatically reversed their enthusiasm for energy stocks and loathing for financials in an abrupt about-turn that sent bank shares soaring and oil and gas companies sinking.

But Merrill said yesterday that the unwinding of the classic bet of the credit crunch may already have been overdone, giving warning that banks across Europe could still be forced to raise between $70 billion (£37 billion) and $120 billion in new equity on top of the $120 billion already raised. Barclays and HBOS looked most vulnerable among UK banks to having to go back to their shareholders for more equity on top of the £4.5 billion and £4 billion respectively already raised.

Merrill said that the rush to buy back into banks may already have gone too far after it stress-tested their balance sheets. It also said that fears over the sliding energy price were being overplayed.

The passion for oils and other raw material stocks and the shunning of financials has been the overwhelming investment story of the credit crunch, a sectoral play on a par with the push out of tobacco and other defensive stocks into technology in the ill-fated boom of 1997 to 2000.

Since last summer, tens of billions of dollars have been pulled from financials and sunk into energy companies but in the past four weeks the sliding price of crude and Banco Santander’s opportunistic bid for Alliance & Leicester triggered an abrupt rethink.

Since mid-July until yesterday, banks have outperformed the market by 10 per cent and energy companies underperformed by 10 per cent. “A lot of people will have been caught out by the brutal nature of that reverse,” David Bowers, a consultant to Merrill, said.

Merrill’s own monthly survey of fund managers showed that the net number saying they were overweight in oil and gas fell from 52 per cent last month to 11 per cent. The return to financials was more modest, with the net number of investors underweight in banks slipping from 57 per cent to 40 per cent.

Bank shares were punished yesterday, with Barclays and HBOS each falling 7 per cent. Royal Bank of Scotland and Lloyds TSB fell 6 per cent.

Financial stocks fell, led by Bank of America Corp. and Morgan Stanley, after Merrill Lynch & Co. downgraded the shares of its biggest competitors and said the credit crisis is "far from over."

Bank of America, the largest U.S. bank by market value, dropped 7.3 percent and Morgan Stanley, the No. 2 securities firm, declined 5.5 percent in composite trading on the New York Stock Exchange. Merrill Chief Investment Strategist Richard Bernstein said investors are "significantly underestimating" the extent of the credit crisis.

Guy Moszkowski, Merrill's top-rated analyst for securities firms, downgraded Morgan Stanley, Goldman Sachs Group Inc. and Lehman Brothers Holdings Inc., his firm's three biggest U.S. rivals, as well as Citigroup Inc., the largest U.S. bank.

"Conditions have deteriorated significantly from July," Moszkowski wrote in a note today. "The typical summer slowdown has been exacerbated by renewed fear over credit, the direction of the economy, and home-price depreciation, along with the sudden about-face in the oil price and hedge-fund losses."

Analysts including Oppenheimer & Co.'s Meredith Whitney and Deutsche Bank AG's Mike Mayo this week cut profit estimates and predicted further writedowns on mortgage-related bonds. Bets in the options market against gains in the S&P Financials Index are within 2.3 percent of a record, Bloomberg data show.

Goldman, Lehman and Citigroup Inc. were downgraded to "underperform" by Merrill's Moszkowski. Morgan Stanley was cut to "neutral" from "buy." Moszkowski said he expects Citigroup to take markdowns totaling $8.1 billion in the quarter on collateralized debt obligations, mortgage securities and auction-rate debt. He added that he sees "potential for reduction or even elimination of the dividend" at Citigroup.

Mayo cut his third-quarter estimate on Lehman, citing concern that slowing revenue from capital markets and writedowns will erode profit. He estimates a third-quarter per-share loss of $2.68, compared with his earlier estimate of profit of 33 cents. Mayo reduced his share-price target to $32 from $42.

"You are going to see stresses continue for financial institutions," said Stephen Wood, who helps manage $213 billion at Russell Investments in New York. "You're beginning to see that macroeconomic slowdown ripple through."

JPMorgan Chase & Co., the second-biggest bank by market value, on Aug. 11 reported a $1.5 billion loss on mortgage-backed assets since the start of the third quarter. JPMorgan shares dropped 9 percent yesterday, the steepest decline in six years, as Ladenburg Thalmann & Co. analyst Richard Bove called the stock "dead money." Today the shares fell 2.7 percent.

Shares of financial stocks also fell as a limit on short selling expired. The Securities and Exchange Commission's rule, in effect for the past three weeks, made it harder to complete sales in which investors betting on a stock decline could avoid borrowing shares for the transaction.

The SEC is investigating whether trading abuses contributed to the collapse of Bear Stearns Cos. in March and the 75 percent drop in Lehman shares this year. Fannie Mae and Freddie Mac each lost more than 80 percent of their value amid speculation the two largest U.S. mortgage buyers may not have enough capital to cover losses from the deepest housing slump since the Great Depression.

In traditional short selling, traders borrow shares and sell them. If the price drops, they profit by repaying the loan and pocketing the difference. The SEC required brokers to arrange a loan before selling short shares of 19 companies. In the first week, short sales plummeted 78 percent compared with the number of trades on July 14, the day before the rule was announced, according to S3 Matching Technologies, an Austin, Texas-based firm that processes transactions for brokerages.

Short interest, or the number of securities that have been sold short and not yet repurchased, in the 19 companies fell by an average of 13 percent in the two weeks ended July 31, New York Stock Exchange data show. Overall, short interest at the NYSE declined 1.5 percent during that period.

The drop contrasts with increased pessimism among investors for financial companies. Short interest for an exchange-traded fund tracking the 88 bank and brokerage stocks in the S&P 500 rose 13 percent during the period, NYSE data show. Open interest in put options on the XLF, as the Financial Select Sector SPDR Fund is known, climbed to 4.61 million contracts yesterday, just shy of the 4.71 million record reached July 18.

Analysts have also turned pessimistic, according to First Coverage Inc., a Toronto company that tracks recommendations from 250 different brokerages. Analysts were more bearish on financial stocks than any other industry group in the S&P 500 last week, down from a two-month high in optimism during the first week of July. "Financials find themselves back firmly entrenched in last place, nearing all-time bearish lows," First Coverage Chief Executive Officer Randy Cass said in an interview yesterday.

"Banks have to reinvent themselves and find new ways to make money, and that doesn't happen overnight," said Tim Ghriskey, who helps manage $2 billion as chief investment officer at Bedford Hills, New York-based Solaris Asset Management. "The strong performance we've seen off the bottom may be a bit premature."

Not everyone is pessimistic. Lehman's largest shareholders increased their stakes in the firm, the No. 4 U.S. investment bank, in the last quarter as its shares fell 47 percent, regulatory filings show. Barclays Global Investors, Vanguard Group Inc., Blackrock Inc. and JPMorgan's asset-management arm were among the eight that raised their Lehman holdings during the period that ended June 30. Vanguard increased its stake by a third, while Barclays's stake jumped 15 percent.

On the other hand, a few (very few!) people do. And those who do are reaching for new pairs of shorts, needing to replaced their soiled ones, every few hours - or minutes.

It really is that bad.

You're not being told on Bubble TV, mostly because people either don't get it or are trying like hell to figure out how they're going to get out of the mess they're in themselves, and are not all that interested in helping you find the door - its not very wide, there are a lot of people in the room with them, the curtains are on fire and they need to get through it first.

Let me give you a few hints, so you might understand:

This is just one (of many) examples. It is the "AA" rated "slice" of an index, specifically, the "Home Equity Credit" ABX index which is on, effectively, swaps on asset-backed paper.

As the name implies, this is Home Equity loans, the "AA", or one step down from the top (AAA) rated debt.

Notice where its trading? 10 cents.

The "AAA" slice is trading at about 50, by the way, and the "A" and "BBB" is in even worse shape.

These are quoted as spreads, or basis points, over the benchmark which is a swap (in this case I believe its the 10y). The important point is the direction of the graph. Higher = worse. In this case, a lot worse, in that these spreads have nearly doubled in less than three months!

But AAA only looks bad until you see this:

If that doesn't peel your whig back nothing will.

Twenty-five hundred basis points over Treasuries, and for all intents and purposes since June the direction of those spreads have been straight up?

Huh? Am I reading that right?

That's Guido-credit-card territory.

Now for the guy who wants to put one of these deals together, realize that the "BBB" piece is just that piece that gets "sliced off." His "composite" cost is probably somewhere around 10%; figure the swap is around 5ish, and then the "blended" spread on all the components once you do your magic winds up at around 500 over that.

That's bad. In fact its real bad; you have to be able to cash flow at that same 10% (of the gross on the deal) to break even, and of course nobody works for free. For all intents and purposes this marks that part of the market as "done", as in "baked", "well", or more likely, "crispy."

Now I want you to sit back in your chair, grab a snifter of quality Cognac, and cogitate for a minute.

Consider the plight of a couple of firms who operate like Hedge Funds (or are Hedge Funds!), buying the slices of that paper and gearing up, making lots of money the last few years. In fact, they crowded most other people out of the market and drove bids so high that money got very cheap for a lot of people in their marketplace.

But now the spreads have blown out on that paper as the underlying loans have started to show stress, and that paper is worth much less. Some might be even tripping "acceleration event" clauses in the structuring, or worse, defaulting outright. Consider those ABX and CMBX charts for just a little while, and then think about the fact that this isn't just residential HELOCs or Commercial Real Estate - it is in fact every kind of loan made to, literally, everyone.

Ok, so here you sit, geared up, oh, let's be generous and call it 20:1, maybe 30:1, maybe even 60:1, and you've been carrying marks at, oh, 98, 99 cents. You're taking losses, and in fact they're pretty big losses, but that's only because you have a absolutely enormous amount of book out there. As a percentage, those losses are quite small but when geared up like this you wind up bleeding out on the sidewalk screaming for a blood transfusion to keep you alive.

But now your accountants or worse, your auditors notice that heh, the ABX.HE says that "AA" debt is 10 cents. CMBX BBB spreads are 2500 basis points over Treasuries, or close to a 30% (!) yield.

You think about the duration times spread for a few seconds and turn white as a ghost at what this implies about the "value" of the paper you're holding, not to mention the odds that it really is a zero, and what's worse is that you borrowed the money to buy it!

Oh, and Mr. Pencil-Neck (that's the Auditor on the other side of your desk) is tapping his shoe on the floor impatiently.

He wants to know, you see, how you came up with that impairment and charge on your last set of financials.

Folks, this isn't bad, its a full-on meltdown, China Syndrome style. Its happening right here and now, under your nose. As this noose tightens further, and tighten it will (notice that all the "stick save" games the government has played have had only transient impacts on the progression of this problem) credit will choke off system-wide - not because people don't want it (witness the desperation of Americans evident in the latest Consumer Credit Report), but because people can't pay - they're over-encumbered and simply unable to support any more debt!

The happy-face folks on BubbleVision are not talking about it, but this does not mean it is not happening.

A new study, released Wednesday morning by researchers at Columbia Business School in New York, argues that a recent rise in mortgage rates has had a significant negative impact on home prices — reducing prices by 10 percent. But we’re not talking about mortgage rates in the sense of the actual rate; we’re talking about rates relative to the spread with 10-year Treasuries, which have gapped out this year to levels rarely seen before.

The research, authored by Christopher Mayer and Paul Milstein, professor of real estate and senior vice dean at Columbia, suggests that continued pressure in the mortgage market and the likelihood of a longer-term upward trend in mortgage rates will keep home prices falling nationwide. “The problems in the mortgage market have put the nation’s housing in a downward spiral that will be hard to break,” Mayer said in a press statement.

Examining house price data from 19 metropolitan areas in the U.S., Mayer determined the relative cost of owning a home in today’s distressed mortgage market, and compared this ratio to where prices would be if the mortgage market were behaving as it has over the last few decades. His analysis found that today’s higher mortgage rates have raised the full cost of home ownership by between 10 and 20 percent.

Mayer’s model suggests that housing markets across the U.S. will continue to decline as mortgage rates increase, including “bubble” markets such as Miami, Tampa and Phoenix in particular, where prices are likely to drop by at least another 10 to 15 percent from their current levels.

He also suggests that many coastal markets such as San Francisco, Boston and New York, where house prices have corrected to where they should be based on economic fundamentals, are likely to keep falling due to deteriorating mortgage markets and broader economic conditions.

Even more stable markets in Texas and the Carolinas that were not as affected by the subprime crisis or worsening economic conditions as other parts of the country, are still likely to experience falling prices due to increasing mortgage rates, Mayer concluded.

When interest rates are low — as they are today — Mayer’s research suggests that house prices are very sensitive to fluctuations in mortgage rates. For the last 20 years, mortgage rates have averaged at 1.6 percent above the 10-year Treasury rate, while in today’s distressed market these rates exceed the 10-year Treasury rate by more than 2.4 percent.

Climbing mortgage rates relative to Treasuries make it more difficult for homeowners with subprime loans to refinance into lower rates, resulting in a greater number of foreclosures, and they discourage potential new homebuyers from entering the housing market, lowering demand. Both of these effects put further downward pressure on house prices, he said.

In case you haven’t heard: option ARMs are a problem, and Countrywide holds ‘em in spades. The Calabasas, Calif.-based lender’s latest 10-Q filing with the Securities and Exchange Commission underscores the pain that’s now flowing through the veins of Bank of America (Countrywide filed a Q2 report because its acquisition wasn’t complete until July 1, for those curious to know).

Countrywide held $25.4 billion in pay option mortgages at the end of June; a full 12.4 percent of those loans were 90 or more days delinquent. Want to know more? Get ready to cringe: 83 percent of the portfolio was underwritten via low-doc or no-doc programs, and 72 percent of those borrowers still paying on the loans elected to make less than a full interest payment in June.

Average original LTV of 76 percent had increased to refreshed LTV of 95 percent — that’s the average for the entire portfolio, folks — by the end of April. What to know still more? Despite a severe delinquency rate well into double-digits, Countrywide’s own recast projections suggest that the worst of the portfolio’s recasts won’t hit until sometime in 2011 ($6.96 billion in projected recast volume, net of repayments).

All of which means that 90+ day delinquency figure really only has one direction to go from here. And Countrywide knows it, too; the company, like other lenders with significant option ARM exposure, has been aggressively looking to restructure loans for borrowers stuck in pay-option mortgages, to the tune of $1.2 billion in troubled debt restructuring this year alone.

Countrywide, by the way, also holds $32.3 billion in home equity loans in portfolio; the performance there isn’t likely to be much better than what’s being seen in option ARMs, although the company didn’t break out credit performance for the area in its filing.While Countrywide’s option ARM holdings are large, the company doesn’t hold the largest such portfolio of loans.

That distinction would go to Wachovia Corp., which holds $122 billion in option ARMs, a substantial part of the bank’s $488.2 billion in total loans; no other U.S. bank has as much exposure to option ARMs in real-dollar terms. The North Carolina-based bank yanked its option ARM lending program earlier in the year, as mounting losses and continuing home price declines made the product unprofitable.

Bank of America has recently touted a commitment to modify or work out $40 billion in troubled mortgage loans over two years in an effort to keep 265,000 customers in their homes; it now seems likely that a good chunk of that total will come in the form of option ARMs via Countrywide.

BofA CEO Kenneth Lewis said that he expects the acquisition of Countrywide to add to profit this year, a sentiment that some analysts have attacked as bluster.

Ten exchanges agreed Wednesday to consolidate their insider-trading surveillance and investigation efforts, turning over the responsibility to the regulation arm of the New York Stock Exchange and to the Financial Industry Regulatory Authority.

The arrangement will eliminate the overlap that would frequently arise when each exchange ran its own surveillance program, and it gives NYSE and FINRA greater jurisdiction to enforce market rules, said Richard Ketchum, chief executive officer of NYSE Regulation and chairman of Washington-based FINRA.

FINRA, a private regulator, will handle insider-trading surveillance for Amex- and Nasdaq-listed securities, while NYSE Regulation will examine NYSE- and NYSE Arca-listed stocks, no matter where in the country they are traded. In the past, NYSE Regulation would not have had jurisdiction in cases involving members of exchanges other than the NYSE, even if the trades in question were in NYSE-listed stocks.

"I think we all recognize that in a world of electronic trading, where there are more venues and more opportunities where people may be able to hide their activity, consolidating the review of insider-trading activity was critical," Ketchum said.

The Securities and Exchange Commission, which in 2006 approved a similar consolidation of surveillance duties in the options market, will accept public comment on the stock exchanges' proposal for three weeks. "We have immediately published this proposal for public comment because of its potential to increase the likelihood that those who engage in insider trading will be caught and punished," SEC Chairman Christopher Cox said in a statement.

The exchanges participating in the agreement are: the American Stock Exchange, the Boston Stock Exchange, the CBOE Stock Exchange, the Chicago Stock Exchange, the International Securities Exchange, the Nasdaq Stock Market, the National Stock Exchange, the NYSE, NYSE Arca, and the Philadelphia Stock Exchange.

NYSE Regulation last year referred 141 suspected cases of insider trading to the SEC, up from the 100 referrals made five years earlier. Typically, more than half the referrals from NYSE Regulation lead to investigations by the SEC, Ketchum said.

Ilargi: I think Evans-Pritchard writes this piece to make an argument for what he would like to be true, not what is. He’s sort of a convert to debt deflation, but may not quite have grasped the issue yet.

Mounting fears of a full-fledged global recession have caused a profound shift in investor strategy over the last month, setting off a powerful dollar rebound and a flight to relative safety in US assets.

The latest survey of fund managers across the world by Merrill Lynch found that expectations of inflation have fallen to the lowest level in six years, an astonishing shift in attitude from the scare of the early summer."People think the credit crunch is mutating," said David Bowers, chief consultant to the report.

"What started as a US financial crisis is morphing into a global economic crisis. Investors now expect a downturn of such intensity that it will prevent inflation from taking hold," he said. Half the fund managers think the world will slide into recession over the next year, and a quarter suspect that it may already have begun.

A blizzard of dire data from Europe, Japan, Canada and Australasia has shattered assumptions that the world economy can decouple from the United States, and there is a growing suspicion central banks have been too slow to respond.

A net 18pc of investors now think inflation will fall over the next year, the most "deflationary" count since 2002. Bets that central banks would have to keep raising interest rates have been unwound almost overnight. Cuts are now expected. "Inflation is viewed as yesterday's story," said the report.

"We have seen an extraordinary sea-change, but this is very controversial. Investors may be reading too much into the fall in oil prices," said Mr Bowers. Energy analysts are deeply split over the outlook for crude after its dramatic 22pc slide from a peak of $147 a barrel in early July.

Merrill Lynch said there had been a "brutal reversal" across the whole gamut of investments as funds switch to a radically different strategy. The dollar has suddenly become the darling of the currency markets. A net 58pc of fund managers think the greenback is undervalued, the highest level since the survey began.

The euro is now the skunk at the garden party: a net 71pc say it is overvalued and most think it will fall next year. David Bloom, HSBC's currency chief, said the greenback's moment of schadenfreude had come, ending a seven-year slide that has called into question its viability as the world's reserve currency.

"It has become apparent that other economies are deteriorating fast, and the whole decoupling thesis has started to come apart at the seams. Canada is frozen over. We have Arctic conditions in Sweden, a landslide in Germany, and the UK is falling off the white cliffs of Dover," he said

"Foreign exchange is a relative concept. It is not that the US is in good shape, just that others are slowing sharply. Central banks have been too worried about inflation when they should have been thinking about growth," he said.

Merrill Lynch said the crowded bet known as "long oil/short banks" had unwound viciously since mid-July, leaving some funds nursing hefty loses. The decision by the US authorities to enforce a temporary ban on short-trading on 17 bank and financial stocks set in motion a swift "short squeeze" that compounded the pain.

"Long oil/short banks has been the dominant trade of the credit crunch," said Mr Bowers. "It was almost the only game in town, so to see such a dramatic reversal raises a lot of questions. Is there something deep-seated in this slowdown?"

Karen Olney, Merrill's European equity strategist, said it was too early to tell whether investors are turning their backs on commodities or just taking profits. "You can only stretch a piece of elastic so far before it snaps back. We think this pessimism on the oil sector is overdone," she said.

Funds are still hoarding cash everywhere until the storm subsides. A net 83pc think the earnings estimates of analysts are "too high" and underestimate the margin crunch that is about to hit companies as unit labour punches higher, especially in Europe.

"Watch out for the profits squeeze in the third quarter. Investors have turned a blind eye to the second-round effects of inflation, such as rising inflation. It will take several months of slowing global growth to be sure that the inflationary dragon has been slain," she said.

The new favourite among the big OECD economies is the United States, where a disaster scenario is (arguably) already priced into battered equities and where the Federal Reserve has taken pre-emptive action to cushion the hard landing. A net 12pc are now overweight US stocks and shares, the highest level of optimism towards Wall Street in six years.

"US equities are back to 2001 levels of popularity. Sentiment has moved a long way. Not so cool Britannia remains unloved," said Merrill. The appetite for UK stocks is at revulsion levels last seen in the depths of the dotcom bust.

In the wider world, Russia is still top dog with a net 56pc of funds overweight, but the data was collected before the country went to war in Georgia. Korea has slithered down the charts. The mood is still jaundiced towards China, Poland, India, South Africa, Taiwan, Malaysia, and Chile. Exporting commodities is no longer enough to lure investors.

The survey is based on 193 fund managers managing $611bn. It is often used as a contrarian indicator, revealing clusters of overcrowded investment positions that are overstretched and likely to reverse.

It is official. With their exporters grappling with a strong currency and banks still reeling from investments soured by the dreaded subprime mortgage crisis, European economies have been shrinking.

The euro zone contracted by 0.2%, quarter on quarter, and grew by 1.5% on an yearly basis in the second quarter, the European Union's official statistics office, Eurostat, said Thursday. The figures were in line with expectations, with no revisions made by Eurostat. Separate data showed Thursday that the economies of both Germany and France contracted in the second quarter.

Germany's economy shrank by 0.5%, which was less than the 0.7% fall expected by economists, while the French economy contracted by 0.3%. Experts had been penciling in a 2.0% rise for France. European government bond prices fell, with the German 10-year bund yielding 4.21%, up from 4.20% late Wednesday in New York.

In Spain, a country whose economy looks especially vulnerable because of its boom-to-bust housing market, gross domestic product actually eked out growth of 0.1% in the second quarter, a figure greeted with skepticism by some analysts because of the steep drops in housing, construction, industrial production and confidence.

With the German figures slightly better than expected, economists are hoping to see some stabilization in the third quarter rather than a second bout of contraction, which would technically put its economy in recession. French finance minister Christine Lagarde dismissed talk of a recession in France, arguing that conditions were very different from the nation's last recession, in late 1992, when interest rates were higher and bankruptcies more frequent.

The last time the German economy recorded a decline was in the third quarter of 2004, when it contracted by 0.2%. The country's statistics office blamed falling household consumption and a slide in its construction sector for the result.

Exporters like ThyssenKrupp and Salzgitter are still managing to haul in profits, though. The two German steel makers posted expectation-beating profits for the most recent quarter on Thursday, as strong demand from Asia helped offset the slowdown in Germany and the euro zone.

The German Federal Statistical Office said foreign trade had made a "positive contribution" to the country's economy, which is the euro zone's largest. On Wednesday, Estonia became the second European Union country after Denmark to enter a recession, and Latvia looks likely to be the next. Data also showed Wednesday that Japan's economy had fallen by 0.6% in the most recent quarter.

Euro zone gross domestic product figures are due out later on Thursday morning; economists are expecting to see a fall of 0.2%.

Concerns about economies outside the United States have been weighing on major currencies, as foreign exchange traders invest more in the dollar. The euro, which has been under pressure in the past few weeks, rose slightly on Thursday morning in London, to $1.49235, from $1.49195 late Wednesday in New York. The dollar meanwhile was up for the 10th consecutive day against a basket of currencies.

Second-quarter GDP figures came in from two other European countries on Thursday: Austria's economy grew by 0.4%, quarter on quarter, down from 0.6% in the previous quarter but in line with expectations. And the Czech economy slowed more than expected, growing 0.9%, quarter on quarter, and 4.5% on an annualized basis. The Czech Republic is lagging behind neighboring Slovakia, which grew 7.6% in the second quarter, although it is still ahead of Hungary, which grew 2.2% in the same period.

Germany may be on the brink of recession but the contraction in the second quarter was smaller than many feared and Europe's largest economy should recover its poise by the end of the year.

Gross domestic product (GDP) contracted by 0.5 percent in the April-June period -- below a Reuters consensus forecast for a drop of 0.8 percent and far smaller than the most negative prediction, for a 1.1-percent contraction.Deputy Economy Minister Walther Otremba said a dip in the third quarter could not be ruled out.

Such a contraction would technically put Germany in a recession, which is generally defined as two or more consecutive quarters of contraction. However, a buoyant labour market, falling oil prices and a weaker euro all point to a recovery later this year.

"The upswing is over: The extremely strong economic performance of recent years is in the past," Beatrice Weder di Mauro, a member of the government's panel of economic advisers, told Reuters. "But I don't see a severe recession."

The Bundesbank struck a similar tone. "The German economy has got to get through a rough patch for growth in the coming months. But overall there's no reason for excessive pessimism based on the development of the first half of the year," the central bank told Reuters in a statement.

The second quarter contraction was marked by declining private consumption, which accounts for over half of GDP.A survey published late last month showed consumers had become more downbeat than at any time since the recession year of 2003 due to concerns about inflation as oil prices soared. Germany's inflation rate held at a near 15-year high in July.

High energy costs dampened real incomes in the second quarter and weighed on consumer' spending, the Bundesbank said. But those price pressures are easing. Crude oil prices hit a peak in mid-July and have since fallen sharply -- a drop that should feed through to consumers, in part at least, and ease the strain on their finances.

"Once you remove the inflation shock, consumer confidence could be relatively robust," said Bank of America economist Gilles Moec. "I'm still fairly optimistic. For Germany, we have chances for recovery by the end of the year."A buoyant labour market in the euro zone's largest economy should prevent a sharp fall in consumer spending.

German unemployment fell by 20,000 on the month in July to 3.250 million, holding the jobless rate at its lowest level in nearly 16 years. "The labour market is for the time being in stagnation mood, but not recession mood, and that is the main reason why I am fairly optimistic," Moec said.

Upbeat outlooks from leading German companies reinforced the prospect of the economy weathering the weak patch. Steelmakers ThyssenKrupp and Salzgitter raised their profit forecasts on Thursday, revelling in a global boom for the metal. Builder Hochtief also raised its 2008 outlook after foreign business boosted quarterly profit.

Foreign trade, a key engine for the German economy, again made a positive contribution to GDP in the second quarter, though this was largely due to a drop in imports. Exports could offer support later this year, aided by a weaker euro.

The single European currency has eased against the dollar this month. The fall should trim the cost of German exporters' goods outside the euro area -- although such currency movements usually take a while to boost corporate competitiveness.

"Cheaper oil and the weaker euro exchange rate are certainly easing the burden for industry. But with the euro it doesn't have an immediate impact," said Ralph Solveen at Commerzbank. German companies are facing weak demand from other countries in the 15-nation euro area, where GDP contracted by 0.2 percent in the second quarter.

However, widespread restructuring in recent years has prepared German manufacturers well for the economic slowdown, and they are tapping demand for their high-end goods in growth markets such as China and Russia.

The VDMA engineering association said it was sticking to its forecast for growth of 11 percent this year in the industrial valve sector, with demand particularly strong from Russia and China. "The outlook for industrial valves remain positive despite the bad news from the overall economy," the VDMA said

The following are excerpts from an interview with former Federal Reserve Chairman Alan Greenspan conducted by David Wessel, The Wall Street Journal’s economics editor.

BOTTOM LINE “Home prices in the U.S. are likely to start to stabilize, or touch bottom, sometime in the first half of 2009, though prices could continue to drift lower through 2009 and beyond.”

WHY IT MATTERS “A necessary condition for an end to the current global financial crisis is the stabilization of the price of homes in the U.S. Stable home prices will clarify the level of equity in homes, the ultimate collateral support for much of the financial world’s mortgage-backed securities. We won’t really know the market value of the asset side of the banking system’s balance sheet — and hence banks’ capital — until then.”

IMMIGRATION “Public policy can hasten this process by not prematurely propping up housing starts and by expanding the underlying demand for homes generally. The most effective initiative, though politically difficult, would be a major expansion in quotas for skilled immigrants. Skilled immigrants tend to form new households, by far the most important source of new home demand.

The number of new households in the U.S. is increasing at a rate of about 800,000 a year, of which about a third are immigrants. Perhaps 150,000 of those are loosely classified as skilled. A double or tripling of this number would markedly accelerate the absorption of unsold housing inventory for sale — and hence help stabilize prices.”

FORECLOSURE AVOIDANCE “It’s a good idea. Foreclosures don’t help anybody. It’s costly to the holder of the mortgage and disaster for the homeowner. In the days before we sliced and diced mortgages into securities, when the borrower got into trouble, he’d come to the assistant vice president of the local S&L and get agreement to stretch out the payments or restructure the loans in a deal that worked for both parties… Until the recent surge in foreclosures, more than half of all loans that went into foreclosure were ‘cured’ without the sale of the property.”

SUPPLY GLUT “U.S. home prices will stabilize only as the current huge 800,000 excess of vacant single-family homes for sale is dramatically reduced and prices deflate to the level consistent with the historical rate of return on owning a home that prevailed before the price surge in the U.S. and elsewhere.”

Mr. Greenspan’s forecast rests on two pillars of data. One is the supply of vacant single-family homes for sale, both newly completed new homes and existing homes owned by investors and lenders.

“New single-family home completions are currently just barely under the rate of home demand generated by household formation and replacement needs. Only early next year will the current suppressed level of housing starts be reflected in completion levels consistent with a sufficiently rapid rate of liquidation to materially reduce the bloated inventory excess.” “We seem to be approaching a peak in the number of new foreclosures, though the number in foreclosure will continue to rise for awhile.”

The other pillar is a comparison of the current price of houses — he prefers the S&P/Case-Shiller National Home Price Index — with the government’s estimate of what it costs to rent a single-family house.

“It’s the imbalance of supply and demand which causes prices to go down, but it’s ultimately the valuation process of the use of the commodity…which tells you where the bottom is. For example, the grain markets can have a huge excess of corn or wheat, but the price never goes to zero.

It’ll stabilize at some level of prices where people are willing to hold the excess inventory. We have little history, but the same thing is surely true in housing as well. We will get to the point where there will be willing holders of vacant single-family dwellings, and that will no longer act to depress the price level.”

FANNIE MAE & FREDDIE MAC “The issue is how you get a viable mortgage market when this is all over. What happens in 2010 or 2011?” What is your opinion of the recently legislated solution? “Bad.” “It does not alter the flawed model. A new regulator does not have that capability.”

“This was the ideal opportunity to come to grips with what is a fundamentally flawed model, which privatizes profits and socializes losses, which is fiscally tolerable in small amounts but in trillions of dollars, it isn’t” “They should have wiped out the shareholders, nationalized the institutions with legislation that they are to be reconstituted with necessary taxpayer support to make them financially viable as five or 10 individual privately held units, and auctioned off.

The affordable housing programs should be put into GNMA; or another government agency. By the time we have the next mortgage crisis, the five or 10 individual companies would have diversified into other areas of finance, and maybe one or two of them would fail. But having been significantly downsized, systemic risk would be avoided.”

Why the government had to back Fannie and Freddie debt: “When Bear Stearns was bailed out, it was inevitable. There’s no credible argument for bailing out Bear Stearns and not the GSEs.”

On the argument that markets would react adversely if U.S. government took the Fannie and Freddie’s debt onto its books: “Untrue. The law that stipulates that GSEs are not backed by the full faith and credit of the U.S. government is disbelieved. The market believes the government guarantee is there. Foreigners believe the guarantee is there. The only fiscal change is for someone to change the bookkeeping.”

The Wall Street Journal's “Greenspan Sees Bottom In Housing, Criticizes Bailout” shows just how stubborn the former Federal Reserve chairman has become. Endlessly out to defend his record, he even wrote a new chapter for his book. The paperback version will be out next month.

The Journal reports Greenspan studying endless statistics, charts and graphs: 800K vacant homes, the quarterly S&P Case Shiller National Home Price Index, and his old time favorite “owners’ equivalent rent”. At a certain price it will be rational to own a home, according to Greenspan. When the market finds that rational price, equilibrium will be achieved and the excess inventory will be used up.

Once we have price discovery, we will know home equity value and mortgage related assets can then be accurately priced. At that point financial institutions will stabilize. Doesn’t Greenspan sound rational? I wrote "Foreclosures will Moderate as Home Prices Continue to Fall" disagreeing; financial institutions will stabilize well in advance of price stabilization.

Greenspan believes that supply and demand will be in balance with a bottoming in the first half of 2009. But, he qualifies that does not mean home prices stop falling. He just means that the supply and demand will be in balance. Greenspan enforces his argument by relating homes to commodities, and reminding us that he traded copper 50 years ago.

Why do I say that Greenspan’s analysis is meaningless? First, homes do not behave like commodities. They are not as fungible as one pound of copper is to another, and industrial markets are different than consumer markets. Second, statics do not take into account the increased cost of operating a home, stagnant wages of the last decade, tighter lending standards, and weaker consumer balance sheets. Third, statics do not take into account that much of the overstock of housing created during the boom is not consistent with current lifestyles.

McMansions built during the boom are now about as valuable as SUVs. Therefore, many vacant homes are either worthless or might take years to sell. Once in a while anecdotal evidence is worth more than statistics. In this case, Greenspan should ask if his conclusion is seated in reality.

I cannot leave Greenspan without citing his exact quotes on Fannie Mae and Freddie Mac, via the Journal:

"They should have wiped out the shareholders, nationalized the institutions with legislation that they are to be reconstituted -- with necessary taxpayer support to make them financially viable -- as five or 10 individual privately held units," which the government would eventually auction off to private investors, he said.

I talked about Greenspan’s relationship with those who would benefit from his remarks in "Paulson tops Gross, Greenspan and Ackman in the Mortgage Battle". It still baffles me how the government could entice a new set of GSE investors after they nationalized and wiped out the first set.

Greenspan has either sold out the national interest for personal gain or has gone completely senile

Global central banks continued to pump U.S. dollars into the banking system, generating heavy demand for liquidity from banks.

The European Central Bank said it allocated $20 billion in a 28-day dollar auction. Demand for the dollars was sharp — total bids amounted to $91.1 billion, more than four times the amount allotted. The funds were offered at a fixed rate of 2.45%, equal to the marginal rate of a simultaneous U.S. Federal Reserve tender and just below the market rate.

The Fed said it awarded $50 billion in 28-day credit at 2.45%, coming in short of the $75.46 billion in bids it received. The Swiss National Bank meanwhile set a minimum bid rate of 2.01% for its latest dollar-denominated auction for up to $4 billion. The SNB said it allotted the whole $4 billion; bids totaled $11.60 billion.

The ECB, the Fed, and the Swiss National Bank began conducting coordinated dollar auctions in December 2007 to alleviate financial market turmoil. Wednesday’s actions came a day after an earlier coordinated liquidity provision for money markets that saw the ECB allocate $10 billion in its first 84-day dollar auction. The SNB at the same time allocated $2 billion to markets, while the Fed offered $25 billion in its 84-day term auction facility.

The extended 84-day maturity is widely seen as an effort to assuage the market at sensitive times such as the end to reserve periods, quarters, and fiscal years when banks have scrambled for cash. Following the dollar auction, one-month funds on the interbank euro money market were quoted at 4.51%, an intraday high, though below a 2008 high of 4.65%. Interbank rates are the rates banks use to lend to one another.

In a separate operation earlier Wednesday, the ECB allocated 50 billion euros at rates of 4.61% and higher in a renewed supplementary three-month refinancing operation.

The court-appointed overseer for healthcare in state prisons today moved to seize $8 billion from the California treasury, asking a federal judge to hold Gov. Arnold Schwarzenegger and California Controller John Chiang in contempt of court.

With the state mired in fiscal crisis, J. Clark Kelso, the federal receiver, asked U.S. District Judge Thelton Henderson to force officials to turn over the money he says he needs to raise prison healthcare to constitutional standards. Henderson, who appointed the receiver as part of an inmate lawsuit, has ordered the state to cooperate with Kelso.

The receiver told reporters today that he took the step "with great reluctance, and yet a sense of firm conviction." "We have fully explored and exhausted every avenue for securing this funding in a manner that least affects California's budget and immediate cash needs," Kelso said. "But the state's leaders have failed to act."

Kelso is building seven new facilities for the long-term medical, mental health and dental care of 10,000 inmates, and he is renovating existing clinics at the state's 33 prisons.

Schwarzenegger spokesman Aaron McLear said in a statement that the administration "will continue to work cooperatively with the receiver and the Legislature to move forward in a fiscally responsible way to provide the necessary funding for the receiver's efforts."

Chiang, who disburses the state's money, also pledged in a statement to keep working with Kelso, but he said he could not turn over any cash without legislative authorization or a court order. "At this time, there is neither," Chiang said. In his court motion, Kelso said he needed the state to provide $3.1 billion in the current fiscal year.

That would increase the state's existing $15.2-billion budget deficit. Kelso said he would need the rest of the money within four years. He also is asking for $2 million in daily fines until the state acquiesces. Kelso said he had asked for a hearing before the judge in September where Schwarzenegger and Chiang would have to appear personally.

The receiver previously requested $7 billion to construct and renovate medical facilities. Schwarzenegger agreed to Kelso's plan and included it when he proposed his budget in January. But legislation that would have authorized borrowing for most of the funding was blocked by Republicans in the state Senate in May.

KKR & Co. and Apollo Global Management LLC, two private-equity firms planning to go public later this year, are turning to debt and distressed-asset investments as financing for leveraged buyouts remains scarce.

KKR, run by Henry Kravis and George Roberts, and Leon Black's Apollo plan to invest more in debt instruments, including mezzanine debt, subordinated debt and leveraged loans, the two New York-based firms said in separate filings this week with the U.S. Securities and Exchange Commission. The move may help offset net losses they recorded during the first quarter of 2008.

Wall Street investment banks have cut back on lending as turmoil in the credit markets forced them to take more than $500 billion in writedowns, losses and credit provisions since the beginning of last year. Announced private-equity deals worldwide so far this year have fallen 71 percent from the same period last year to $179.4 billion, according to data compiled by Bloomberg.

"The mega-funds who are going public are looking for alternative revenue streams with more predictable cash flows," said John O'Neill, a partner with Ernst & Young LLP in New York. "They're having difficulty getting financing for deals and they're always looking for opportunities for returns."

Banks, stuck with a $230 billion pipeline of leveraged loans promised to buyout funds, reduced the backlog to less than $47 billion by selling the debt at discounts, according to Standard & Poor's. In February, loan prices hit a record low of 86.3 cents on the dollar.

"We're in a situation where smart people can look at debt opportunities and recognize real arbitrage," said Randy Schwimmer, senior managing director of New York-based Churchill Financial Group LLC, which provides financing for private-equity deals. "It's a lot easier right now to distinguish between good debt and bad debt opportunities."

KKR had a net loss of $117.9 million in the first quarter as the value of the companies it owns fell. Its fixed-income unit has seen assets under management rise to $11 billion as of March 31 from $800 million when it started up in 2004. Of that current total, $8.2 billion is in structured-finance vehicles, a regulatory filing yesterday said.

Now KKR intends to invest more in so-called mezzanine financing, a hybrid of equity and debt that is common in leveraged buyouts. The firm also is expanding its infrastructure and real- estate businesses. KKR said earlier this month its capital-markets division was joining with Goldman Sachs Group Inc., Citigroup Inc. and Lehman Brothers Holdings Inc. to underwrite a $1 billion debt offering for SunGard Data Systems Inc. in its acquisition of GL Trade SA.

Apollo, which reported a quarterly loss of $96.4 million in a regulatory filing Aug. 12, touts distressed-debt investing as a focus for growth. "At the present time, as a result of the current supply and demand imbalance in the global credit markets, we are investing primarily in senior and subordinated debt securities," Apollo said in the filing.

Black also noted in a Feb. 29 letter to investors in his Apollo Management LP that he had placed $1 billion in distressed securities, including the debt of companies the firm owns. Past deals include the purchase of casino company Harrah's Entertainment Inc. and U.S. real-estate broker Realogy Corp. Blackstone Group LP, manager of the world's largest buyout fund, earlier this year agreed to buy hedge fund GSO Capital Partners LP for as much as $930 million to expand its credit and distressed-debt business.

GSO, headed by Bennett Goodman, helped Blackstone beat analysts' estimates in its most recent quarter. The hedge fund accounted for about 15 percent to 20 percent of profits and revenue in New York-based Blackstone's unit that invests in and manages hedge funds. Blackstone shares have fallen more than 40 percent since the firm's June 2007 IPO.

As the private-equity firms diversify beyond LBOs, they may collide with investment banks facing a similar identity crisis amid a dearth of IPOs and declining fees from investment banking. "The real question is what business is everyone going to be in," said Linda Gridley, founder of Gridley & Co., a merger and acquisitions advisory firm based in New York. "The business models for the large Wall Street firms and the private-equity firms have to transform."

Tensions between the Treasury and the Bank of England intensified again as Mervyn King, the Bank’s Governor, abruptly dismissed measures being considered by Alistair Darling to end the mortgage drought. Mr King signalled his strong opposition to a move being examined by the Chancellor to expand the Bank’s emergency financing program — the Special Liquidity Scheme — for lenders.

The Governor also poured scorn on a second, more controversial measure where the Treasury would temporarily guarantee high-quality mortgage-backed bonds to help struggling lenders to boost the funds available for mortgage lending. Mr King’s defiant move to dig in his heels against the plans comes after The Times revealed that the drastic steps to revive the near-dormant mortgage market are under active consideration by Mr Darling.

The Governor’s opposition threatens to again inflame the Bank’s tense relationship with the Treasury, which saw the institutions at loggerheads during the Northern Rock crisis. Mr King has always insisted that, contrary to claims by the Chancellor the Bank’s £50 billion-plus Special Liquidity Scheme, backed by the Treasury and introduced in April, was not designed to breathe life into a mortgage market where borrowers are struggling to find home loans.

Yesterday, the Governor again spelled out his view that the scheme, under which lenders can swap mortgage-backed securities issued before the end of 2007 for easier to trade Treasury bills, was only aimed at relieving financial stresses on banks, and could not be used to boost mortgage lending. He added that the scheme in its present form would still close, as planned, in October.

Mr Darling is believed to want to allow banks to swap new issues of mortgage-backed securities through the scheme. Yet Mr King argued that such a move offered no solution to securing greater availability of home loans.

“Funding is not something a central bank can supply,” he said. “The Bank can swap the stock of assets from illiquid to liquid form. It can’t provide funding to finance investment. That has to come from mobilising savings in the economy. That’s what the financial sector is there to do.”

The Governor poured scorn on the idea of a public backing for new mortgage securities. “It would be a very dangerous move to [have a] situation where the Government saw its major role as guaranteeing lending. “Why should the taxpayer take on the risk of borrowing by individual borrowers, some of whom are risky? It’s the lenders who should take the risk...

“We don’t guarantee lending to other forms of borrowing. There is no reason why in the long-run you need any guarantee of lending to the mortgage market.” Mr King said that the credit crunch afflicting mortgage markets still has some way to run as banks face further losses on past excessive lending. “That we haven’t seen play out yet, so we have to go through that process.”

He said that markets were now directing more attention at the funding of individual institutions, and the viability of their business plans. His comments came as the Bank boosted hope of cuts in interest rates by the end of the year, or early next, that could offer some support to the slumping housing market.

City expectations of eventual rate cuts leapt after the Bank forecast that inflation would tumble back below its 2 per cent target over two years, after peaking at 5 per cent in the autumn.

A rash of market bets on a rate cut by December sent the pound tumbling to an 11-year low on its trade-weighted index, which closed in London at 90.8. The pound tumbled below $1.90 against the dollar, ending the day at $1.8651, its lowest since October 2006, and lost 1.5 per cent against the euro, which climbed to 79.71p.

Shares in Bradford & Bingley, the beleaguered UK bank, yesterday slipped below the price set for its £400m rights issue, leaving the underwriters UBS and Citigroup stuck with potentially millions of pounds worth of stock unwanted by existing investors.

The B&B shares slipped to 54.75p, lower than the 55p-per-share rights issue price for the first time this week, with the process set to close at 11am on Friday.

The rights issue has been sub-underwritten by high street banks including Abbey, HBOS, Barclays, RBS, Lloyds TSB and HSBC, which will also be nervous after the weak response to the deeply discounted rights issue launched by its larger rival HBOS last month, after its shares fell below the issue price.

Some of the group's largest investors, comprising Legal & General, Standard Life, M&G and Insight have also pledged to pick up some of the unwanted rights. B&B's issue will close shortly after the majority of shareholders rejected HBOS's offer in July. Investors, making up 8.3 per cent of the shareholder base, picked up only 30 per cent of the shares on offer.

The take-up was so low after the group's share price traded below the rights offer in the days leading up to the close of the offer. It has been a tough year for the banks, especially those providing mortgage operations, in the wake of the US sub-prime crisis and stories that the deteriorating UK economy could be heading for recession.

There had also been fears that the downward spiral in HBOS's shares had been caused by hedge funds short-selling the stock, which moved the FSA to put in emergency legislation to disclose any short positions.B&B's shares have been among the worst hit in the sector, slumping from over 400p when the credit crunch hit.

Its rights issue has been particularly tortuous. It announced the plan to raise money in May, only a month after scorning the idea. The following month it slashed the price from 82p and announced private equity house TPG would be paying £179m for a 23 per cent stake.

The group then fought off a rival proposal from Clive Cowdery's Resolution, which proposed, with the backing of the four large shareholders, to take effective control of the group with a £400m cash injection. The B&B board, headed by Rod Kent, dismissed the counter offer, angering shareholders, only to see its own plans almost collapse the following month. In the wake of a Moody's credit downgrade, TPG walked away.

The Financial Services Authority and the Bank of England encouraged the move after they had received assurances from the four shareholders that they would step in.

There has been an increased focus by the media on the ongoing disruption in the auction-rate security (“ARS”) market. While failures in ARS in 2007 were limited to certain, higher-risk securities, the entire market for ARS collapsed in the first quarter of 2008.

Since that time, the spotlight has been predominantly on the lower-risk structures of ARS that represent the vast majority of the market. There are three types of ARS that fit into this low-risk basket: student loan-backed ARS, municipal tax-exempt ARS, and issues from closed-end funds.

These types of issues have a lower risk profile because they either have been structured with higher levels of collateralization or have sufficient cash flows to support interest and principal payments. According to Karl D’Cunha, Senior Managing Director at Houlihan Smith & Company, a firm that specializes in the valuation of ARS:

These type of low-risk ARS are failing auctions because of a lack of liquidity in the market, not because of deterioration in credit. In other words, it’s a liquidity issue versus a credit issue.

This highlights an important point: the majority of the ARS market is comprised of lower-risk securities that are failing auctions because of illiquidity in the market.

The media in general have ignored the riskier types of ARS when discussing possible resolutions to the current crisis. It is important for treasury managers to understand that while certain potential solutions may exist for the less-risky ARS, these solutions may not be applicable to the riskier ARS issues.

ARS are financial instruments designed to provide a way to finance long-term obligations at short-term interest rates. Through an auction process, interest rates adjust at predetermined periods—typically every seven, 28 or 35 days—with the frequent interest rate resets giving the security a risk-profile similar to a shorter-term security.

ARS are typically structured with a maximum interest rate that protects issuers by prohibiting auctions that would result in a rate higher than a specified level. Due to the current credit market environment and the lack of liquidity, many ARS issues have been “failing.” It is important to note that an auction failure does not necessarily denote a default in the security, but is merely indicative of a liquidity issue.

Although the current spotlight is on lower-risk ARS structures, higher-risk structures exist and in certain cases represent a high concentration of a company’s shortterm investments. Although these structures only encompass a small fragment of the overall ARS market, they are important to understand.

Some of the most complex ARS were issued as part of consolidated debt obligations (CDOs). For example, Lakeside CDO I, Ltd. issued its most senior tranche in the form of an ARS. These CDO structures typically made investments that included tranches in other CDO (“CDO2”), making them highly nontransparent. Additionally, credit issues have surfaced in these securities due to investments in sub-prime MBS and ABS.

Another high-risk structure known as the contingent capital structure involves monoline bond guarantors. An auction rate preferred is issued by a trust with the proceeds invested in high grade collateral. However, to generate additional income the trust grants a put right to a monocline bond guarantor which allows for the issuance of the monocline’s preferred stock in exchange for the trust’s assets.

Thus, this structure exposes the holder directly to creditworthiness of the involved monoline. The various series of Grand Central Capital Trust, a notorious issue within this group, granted Financial Guaranty Insurance Company the right to issue its preferred stock to the trust in exchange for the trusts assets. Given FGIC’s current dire financial position, it now seems that the once unimaginable is now more likely than not.

Another class of high-risk ARS were issued by credit derivative product companies (CDPCs). CDPCs are operating companies that sell protection via credit derivatives. CDPCs are similar in concept to monolines, however unlike monolines they are not regulated as insurers and take on risk using derivative contracts rather than insurance policies. Many CDPCs, such as Athilon Capital Corp., issued ARS as part of their capital structure in the same way a corporation typically issues longterm debt.

Another class of ARS involving a high degree of risk centered around credit-linked notes (CLNs). CLNs are created through a Special Purpose Company [SPC], or trust. These trusts issued ARS and used the proceeds to purchase AAA securities. These AAA securities were used as collateral to enter certain credit derivative swap contracts [CDS].

For example, certain series of Pivot Master Trust were invested in a CLN that invested in a AAA-rated note backed by credit card receivables. This note was then used as collateral to enter a CDS whereby the default risk of 125 companies was assumed at specific tranche levels.

Another structure was issued for the benefit of life insurance companies. Regulation XXX stipulates specific levels of capital reserves insurance companies must carry. Oftentimes, the statutory level of capital demanded by Reg. XXX is greater than the economic level of necessary capital determined by actuarial models. In order to finance the difference, the risk of policies is transferred into a captive insurance company via a reinsurance contract and ARS are issued to raise capital.

The proceeds are invested, and generally the expected life of the securities is less than the stated maturity, as redemptions are made as policies are termed or benefits are paid out. Typically, issues of this ARS structure were insurance by a monocline bond guarantor.

The riskier structures of ARS began failing auctions in the third quarter of 2007, long before the overall market for ARS fell apart. According to Brian Weber, Senior Analyst at Houlihan, “The riskier classes of ARS were the first to start failing auctions and they will be the last to experience successful auctions again, if ever.”

Many holders of safer auction rate securities enjoy significant yields in the present market on their investments. For these safer ARS, yields are significantly higher than straight-bond issues of similar credit. Issuers are being penalized and paying higher rates because of the ARS structure. Therefore, market resolution is foreseeable through either refinancing or successful auctions.

The opposite is true with many of these high-risk ARS. Many of these securities have relatively low maximum interest rates. Thus, issuers of these securities presently enjoy paying yields much lower than yields offered on straight-bond issues of comparable credit. This results in a disincentive for issuers to refinance these issues. There may be exceptions to this general statement.

For example, certain incentives exist for counterparties to restructure issues of the CLNs. However, in general there is strong fundamental support for the less-risky ARS, while that support does not exist for the riskier classes of ARS. Given that the overall focus has primarily been on the less-risky classes of ARS, it skews the market outlook for holders of the more complex ARS.

Therefore it is paramount to distinguish between the risk levels involved in various classes of ARS. Discussion of ARS and potential resolutions to the current market disconnections will most likely not be applicable to all classes of ARS.

Share prices have come alive in recent weeks, aided by a number of ostensibly positive developments. Providing a big boost, of course, has been sell-off in crude oil and other commodities.

To the optimists, the moves are a clear sign that the inflation bugaboo has gone away. That means the Federal Reserve can once again drop its guard and open up the monetary spigot, enabling the long-term bull market to reemerge. Then again, maybe not.

In fact, evidence suggests that what the Fed does no longer matters. It was almost a year ago, for instance, that Bernanke & Co. began to ease policy, with fed funds having fallen by 325 basis points since then. Yet credit market conditions have worsened, 30-year mortgage rates have ticked higher and the S&P 500 has lost more than 12 percent. So much for the power of the Fed.

Nonetheless, optimists will insist that falling prices for raw materials means that corporate America can look forward to another round of bottom lines being bolstered by fat margins. But is that likely?

Given that energy and other commodity markets have supposedly been buoyed by growth outside our shores, logic suggests that the recent sell-off in those markets indicates activity in Asia and elsewhere is softening -- just like in the U.S. If that is the case, how long will it be before gluts and competitive pressures force businesses around the globe to cut prices at a faster pace than costs are falling?

Ignoring that, some are insisting that the run-up in the dollar indicates that investors are seeing a light at the end of the tunnel for the beleaguered American economy. That means domestic consumption can pick up the slack as demand softens overseas.

But is that really why the dollar is rebounding? Or does it reflect something else? Arguably, the trigger for the recent turnaround is a sudden recognition that growth is faltering in places like Europe and Asia. In other words, currency markets are signaling that the rest of the world is poised for a bit -- or, perhaps, a lot -- of downside catch-up with a weakening U.S.

That's still not enough for some. Diehard bulls also point to the recent turnaround in the financial sector. To be sure, the one-month recovery in the shares of banks and brokers has bolstered the broader market. Indeed, given the role that financial shares played in undermining investor confidence over the past year or so, it's not surprising that some investors would view hefty gains in the financial sector as a reason for optimism.

But why are financial stocks doing better? Is it because the bad news is fully factored in? Or, as is more likely, is it due to technical factors? No matter how you slice it, it is hard to ignore the fact that the sector bottomed following a July 15th "emergency order" from the SEC barring naked short-selling in the shares of Fannie Mae, Freddie Mac and 17 large investment banks.

Many of these stocks have also seen their short interest ratios drop over the span. But starting on Wednesday, that ban is set to be lifted. And investors will have to focus, once again, on the fact that this critical sector has yet to come to grips with a surging tide of red ink and a litany of legal and other woes.

All in all, then, it seems that many of the reasons why investors have become more optimistic lately don't hold much water. In fact, it won't be long before they discover that their bullishness is -- shall I say -- all wet.

The dollar's long downward slide may be over, but more significantly, a bull market of historical proportions in commodities may be on its last legs. The two trends are by no means unrelated, and it's not coincidental that they're happening simultaneously.

There are both fundamental and speculative reasons for both trading patterns. Let's take a closer look and see why they're happening and what they mean. The dollar has been gaining some impressive ground, now trading at its strongest level in almost six months, and has risen almost 8% since hitting a low in March. The greenback's recent ascent is being driven by a couple of factors.

First, the Fed is taking a tougher public stance against inflation by signaling it won't cut interest rates any further. The Fed ended its rate cuts in April, then increased its inflation rhetoric, and in August said in the face of weakening economic activity that it had "significant concern" regarding the upside risks to inflation. The expectations for higher interest rates, or for interest rates not to go any lower, can support a currency by making a country's assets look more attractive, since investors earn a higher return on funds.

Second, the global economy is weakening. According to Tony Crescenzi of Miller Tabak, England is moving toward recession, Germany is expected to post a negative GDP reading for Q2, Japan is moving toward recession, and even China is showing signs of slowing.

Just last week, the head of the European Central Bank voiced concerns about Europe's growth prospects, which spurred foreign exchange traders to revise their bets that the ECB would raise interest rates later this year. Looking East, China's July consumer inflation slowed, giving the Chinese more leeway to cut rates, which should deflate the yuan. As the rest of the world weakens, the US, and the dollar, looks better on a relative basis, despite the fact that the US economy is also struggling.

Meanwhile, as the dollar strengthens, investors have been dumping once popular commodities like gold and platinum, and oil has slid. The two trends - dollar up, commodities down - are not unrelated. In recent years, the dollar has demonstrated an almost perfect inverse pattern versus energy prices. This is not by coincidence - commodities generally move in contrary direction to the dollar as an inflation hedge. The pattern has sustained itself, except this time it's going in reverse.

As the dollar has started to climb, oil showed signs that its long rise may be over. For instance, oil markets would normally react negatively to news of war in the Caucasus, a critical oil-exporting region. The fact that crude prices kept falling in the wake of the Russian invasion of Georgia suggests that traders are now overwhelmed by a belief that the world economy is in worse shape than expected.

What's happening, in addition to fundamental reasons, is a massive unwinding by traders of two major positions. For the better part of the past 28 months, many investors have been long on the same side of the market in a variety of commodity-linked trades.

This was a correct long term bet on commodities such as copper, oil, soybeans and metals to fuel the growth of China, India and other fast growing economies. However, as the economies of India and China weaken, commodities look less attractive, and all of a sudden the U.S. dollar becomes a more attractive safe haven. Therefore, while the commodity traders start to unwind their long positions, they're simultaneously taking off the table their bets against the dollar.

Hedge funds and other speculators are not only selling their long positions in commodities, they are actively increasing their net- short positions against those very commodities. Speculative short positions outnumbered long positions by 5,550 contracts on the New York Mercantile Exchange in the week ended August 5, according to the Commodity Futures Trading Commission. Net-short positions rose by a whopping 741% from a week earlier.

There are also fundamental reasons for the drop in oil. The US and Chinese economies are both slowing, which reduces demand for petroleum and other natural resources. China's July crude-oil imports fell 7% from a year earlier. This is not only due to a slowing economy, but to record oil prices, which has discouraged Chinese refiners from purchasing raw material to process into fuels.

The International Energy Agency, which guides the energy policies of 27 member nations in Europe, Asia and North America, also lowered its demand forecast to 48.6 million barrels a day for the year. In the US and elsewhere, high prices at the pump are also contributing to reduced demand.

Even gold, the safest of safe havens, has been taking it on the chin in the flight away from commodities. Gold is now at its lowest price in almost eight months; last week gold fell to $801 an ounce before recovering slightly to stand at above $815. Platinum and silver also dropped to their lowest levels since December. Gold fell for an eighth straight session, the longest slide since 2001, on speculation that the dollar's strength will reduce demand for the precious metal as an alternative investment.

But we can't officially call an end to the bear market in the dollar, nor to high oil prices. If the economy continues to deteriorate over the third and fourth quarter then the dollar's recent gains will be reversed. We also may not have seen the last of high oil prices. The wild card: Russia's invasion of Georgia may disrupt oil supplies. There's always the possibility of turmoil in or the Middle East, and then there's hurricane season to worry about.

Still, investors can at least take heart in the fact that the dollar's long inexorable tumble, and oil's near record climb, are at least taking breathers.

Never expect the market to be rational because it simply isn't. The fundamentals are awful, but fundamentals don't drive markets - emotion-based herding behaviour does. This is just a bear market rally - sharp as such rallies often are. Doug Noland (in yesterday's Debt Rattle) put it very well when he described it as a 'melt-up', shortly to be followed by a melt-down.

We're already late in this rally as it's been going on since mid-July. It's maximum potential should be in the vicinity of the trendline from 1974 that was broken during the last phase of the decline, which would take the market to the low 12,000s. A return to test the underside of a trendline is commonly called a 'kiss good-bye', as the market would then resume the larger trend. The market need not necessarily reach this level before resuming its decline though.

When the rally is over, we can expect a sharp reversal heralding the beginning of a more significant fall than we've seen so far over the last year. I would expect this phase to last until late autumn and to include or culminate in something people are likely to call a crash (although it will probably only be the first of several such cascading events). I think (at the very least) the market will break through the October 2002 (about DJIA 7500) this year, with much more downside potential to come thereafter. I'd be surprised if the DJIA was over 1000 by the end of 2010, and even then I think there'll further to go to the downside.

I'm expecting 2009 to be the year of financial panic for the general public, as the economic effects of financial losses sustained this year and next begin to bite very hard. It should be war in the labour markets for a start, as organized labour tries (and fails) to resist huge cuts in wages and entitlements.

Karl Denninger had a strong essay today concerning the ABX and CMBX charts, as is linked in today's Rattle. Since I don't follow these charts, are they a reliable indicator depicting the turmoil and meltdown in the financials?Anonymous Reader

i would add that the global economic integration is the 800 lb gorrila in the room.If/when the US and european economic system stumble food supplies around the world are in trouble, if thailand and eqypt are banning exports due to food prices now, what happens when global food markets fall apart? Without writing a book, the food, energy and financial systems are all interlinked at this point.

Stoneleigh -- You share the admirable ability of your co-host to say a lot in very few words! Given your expectations for historic turmoil in the financial and commodity markets, where do you see a prospect for safe haven, if any? GSJ

If you are old enough to remember manual transmissions, you will remember a technique we used to start a car if the battery was dead. You get it rolling down hill(or friends pushing it to pick up speed), then popped the clutch to get the engine to turn over and start.

I believe that is a good analogy to what was just attempted in the markets. Let it roll downhill in the 2nd quarter, building up commodity positions, then dumping them, slamming the equity shorts in the 3rd, sending them down in flames. This then sucks in what money is left on the sidelines long in equities. This of course is a temporary phenomena, the battery is still dead. But it's possible to create the illusion of life in the markets. I think hopes of blowing a new bubble is nonsense. That wealth evaporated, and everyone still has 3rd degree burns.

This is just slight-of-hand.

Yet if the key dynamic is instead a bursting leveraged speculating community bubble, entirely different dynamics are now in play. Enormous short positions have built up, the vast majority as part of "market neutral," "quant" and myriad risk hedging strategies.

If today's dislocation develops into a significant unwind of these positions, the market immediately then becomes vulnerable to a disorderly "melt-up" followed almost inevitably by a sharp reversal and disorderly decline. The unwind of bearish speculations and hedges would be a most problematic market development, unleashing a final bout of speculative excess and disorder that would set the stage for a major market crisis.

I think (at the very least) the market will break through the October 2002 (about DJIA 7500) this year, with much more downside potential to come thereafter. I'd be surprised if the DJIA was over 1000 by the end of 2010.....

My opinion would be primarily: a lot of desperate busted gamblers, praying that the next throw of the dice will make their money back. We know how well that works.

"Ten exchanges agreed Wednesday to consolidate their insider-trading surveillance and investigation efforts, turning over the responsibility to the regulation arm of the New York Stock Exchange and to the Financial Industry Regulatory Authority."

LOL! Hot damn; we only have to subvert ONE "authority" now, not hide things from 10!

snuffy said: people are not like the '30s.They are one hellava lot meaner,and lost that faith in .gov and the church...

I've seen this on several blogs and I can't let that slide. People have always had the same level of "mean" - and the 30's were no different. In America, for example, lynchings were quite the rage at that time. Is that what people are referring to when they say that people were somehow kinder? The Holocaust began in the 30's and there was a brutal civil war in Spain. I'm sure I'm missing plenty of other events of the time period that point to the universal trait of humans - destructiveness. This has never changed, and I don't think it is possible to change that on a mass scale.

I too have seen this frequently on other blogs and I think that 'meaner' is an over simplification, but the times have changed in a meaningful way since the 30's.

The urban/rural ratio has changed in favor of cities and people are more dependent on transaction denominated in dollars. Fewer people are self reliant or capable of providing for their basic necessities without a steady income. Houses are less likely to be heated with fire wood which only needs to be gathered and more likely to be heated with gas or oil which needs to be paid for. The percentage of the population involved in agriculture has also declined, fewer small farmers in resilient communities and more industrial agriculture dependent on long and complicated supply chains. A failure of the system is going to be far more detrimental to modern Americans than it was in the 1930's because more people are further removed from basic resources and the means of production.

Social structures have also changed significantly from extended families living together in the same area for generations to dispersed nuclear families that move frequently. People also change careers and jobs more often these days. More time is spent in solitary activities than community activities, Single Occupancy Vehicles, cubicle, television, etc. The social bonds are not as strong as they used to be so social cohesion is less likely to hold things together when the system is stressed.

This time around the situation is likely to worse than the great depression and several social and demographic factors are less favorable so things will likely get uglier. People aren't any meaner or nicer than they were, but their circumstances have changed.